Monday, October 31, 2005

What a roll! Maybe it is time to talk about momentum blogging! ;) Yet another cool paper!

Roychoudhury and Abbott tie long run underperformance of IPOs (See Ritter 1991 or Loughran and Ritter 1994) to a lack of liquidity (the Amihud and Mendelson 1986 idea).

In Roychoudhury and Abbott's own words:

"We construct portfolios of IPOs with positive and negative excess liquidity during the first year after IPO issue. While overall we find IPO underperformance in the long run, we show that positive and negative excess liquidity portfolios perform differently. We show that positive excess liquidity portfolio underperforms the negative excess liquidity portfolio during next few years. We show that the above effect holds for portfolios constructed in the event time and in calendar time, for equally weighted and value weighted portfolios, and for size or industry benchmarks....Our result has significant implications about the role of observedliquidity as an indicator of future returns."

To dive in a bit deeper:

* The paper "support[s] the contention that portfolios of more liquid stocks on average provide investors with significantly lower returns than more illiquid stock portfolios even after adjusting for risk. We find IPOs underperform in the long run even after the accounting for liquidity, industry, size, market and year effects."

* The paper uses two measures of liquidity: the so-called standard "spread" based measure as well as a new measure Lambda which is based on turnover and price. Again in the authors' words (see the paper for a more detailed description!)

"lambda is a measure of the observed level of liquidity, with higher levels signifying that the current order flow in the market can absorb larger volumes of trading without impacting prices."

Cool paper! I can not wait to see what this does to other "anomalies" and even pricing models in general! (come on CAPM ;) )

Wednesday, October 26, 2005

Some takeovers are good (value enhancing), others are bad (value destroying).Why the difference?One easy explanation is that managers often have incentives (such as empire building, hubris, pay tied to size, ego, diversification) to do a merger that is not in shareholders’ best interests.Masulis, Wang, and Xie examine this by looking at the returns to acquiring firms and relating these returns to the corporate governance in place at the firm.

T

o some degree the market for corporate control and corporate governance at the firm itself can force managers to look out for shareholders.Thus firms with anti-takeover provisions (ATP) in place make good candidates for areas where managers might be more tempted to do acquisitions that increase managerial well-being at the expense of shareholders.

Examining over 3000 acquisitions from 1990 to 2003, Masulis, Wang, and Xie find strong support for this hypothesis.In their words:

“More specifically, acquisition announcements made by firms with more ATPs in place generate lower abnormal bidder returns than those made by firms with fewer ATPs, and the difference is significant both statistically and economically. This result holds for all the corporate governance indices or subsets of ATPs we consider and it is robust to controlling for an array of other key corporate governance mechanisms, including product market competition, CEO equity incentives, institutional ownership, and board characteristics."

Simply put, this is more evidence that not only are antitakeover provisions bad for shareholders, but it shows a specific path by which these diminish shareholder wealth.

Not centent with just one important finding, the authors also look at other control or governance mechanisms on the premise that if ATPs lower returns, good governance measures will increase acquiring firms' returns. They also find support for this hypothesis:

"acquiring firms operating in more competitive industries experience higher abnormal announcement returns, as do acquirers that separate the positions of CEO and chairman of the board."

Tuesday, October 25, 2005

James and Karceski report that firms who have poor IPO performance get more than just price stabilization in the after market. However, while price stabilization tends to end relatively quickly, the firms whose IPO did poorly also get longer term more favorable coverage in the period following their IPO. This supports the "booster shot" hypothesis.

"Firms with poor aftermarket performance are given higher target prices and are more likely to receive strong buy recommendations, especially by analysts affiliated with the lead underwriter. This favorable coverage is relatively short-lived, lasting for only the first one or two analyst reports, typically less than six months."

What is so cool about this finding is that James and Karceski do not find the same degree of positive recommendations for stocks that went up immediately after their IPO. This finding is important for it seemingly differentiates the momentum stories from the so-called "booster shot" explanation.

"Another alternative is that analysts pre-commit to provide more than a favorable recommendation. As suggested by Michaely and Womack (1999), analysts may commit to provide a "booster shot" by increasing the strength of their recommendation in the face of an unfavorable market response to the IPO. This argument suggests a negative relationship between strength of affiliated coverage and stock price performance."

The findings?

"Lead analysts post much higher relative target prices for IPO firms thathave non-positive initial returns and for firms that trade at or below the IPO offer price when coverage is initiated. For these broken deals, lead analyst target price ratios are on average more than 26 and 36 percentage points higher than target price ratios for firms with zero or negative initial returns or for firms with non-positive return to coverage."

To control for the "of course it is not a strong buy, it has already gone up" phenomena, the authors use a group of analysts that were not associated with the IPO. The authors find that analysts associated with lead underwriters are more positive on the stock (which is consistent with the booster shot hypothesis):

"Lead analysts are also more optimistic relative to other analysts in broken deals in their recommendations as well. The average lead analyst target price ratio for broken deals is 14 percentage points higher than the average target price ratio set by other analysts."

Interestingly the ranking of investment bankers seems to matter (or at least the ranking of their clientele).

"Virtually all (96%) of the 85 broken deals underwritten by a top-ranked underwriter received coverage. In contrast, only 53% of broken deals underwritten by less prestigious underwriters received coverage. The percentage of IPOs underwritten by top-ranked underwriters that receive coverage does not differ significantly by whether or not the IPO is a broken deal. In contrast, brokendeals underwritten by less prestigious underwriters are significantly less likely to receive coverage than successful IPOs underwritten by less prestigious underwriters (the t statistic is -3.68). Thus, one reason to use a top-rated underwriter appears to be a higher likelihood of analyst support if returns are poor in the aftermarket."

As most anyone in industry will tell you, managers often play games with R&D spending. Whether it is for their own "pet projects" or to further some cause within the firm. Of course, this should not be surprising as no where are information assymetry probelms more severe than in R&D spending.Bange, De Bondt, and Shrider now provide empirical evidence of this game playing with respect to managers trying to "manage" earnings. This is because R&D expenditures (for which there is much discretion as to the timing) lower earnings.

The authors find

"find ample evidence suggesting that executives, on average, distort R&D investment decisions so that they may improve their chances of meeting analyst expectations."

This finding, which is based on firms with large R&D spending over the past two plus decades, is consistent with previous survey based work (for instance Graham, Harvey and Rajgopal’s (2004)).

Cendant is giving us a near perfect example of the diversification discount. The basic idea is that firms sell for less when they are made up of multiple lines of business. This has been the a edbate as to whether this is real or whether we are measuring the wrong thing. For instance we do not see the firms' apart from the start.

That said, it appears that most now acknowledge the existence of a discount. Cendant, after denying it for years, is now talking about splitting itself up to remove the discount.

Thursday, October 20, 2005

It is not new, but we just covered it in class and I think many of you might be interested. It is a brief overview of the Equity Risk premium through time by Clark and Silva.

Short version: Expect the equity risk premium to be lower moving forward.

From the paper:

"Expectations for the long-run equity risk premium play an important role in asset allocation decisions because the policy asset mix between equity and fixed income depends on the tradeoff between expected return and risk. The higher the expected equity risk premium the more equity will be held in the portfolio. To give some perspective about what might be reasonable to expect in the future, we first show historical values for the U.S. equity risk premium. Second, we break the equity risk premium into its component parts and suggest some reasonable values for the components going forward. Finally, we present expectations from several other written sources."

I especially suggest you look at page two; the tables are excellent for class!

Thursday, October 06, 2005

Continuing our look at some papers from the FMA Meetings, Del Guercio, Wallis, and Woidtke give us a look at whether boards of directors actually listen to their voting shareholders and if they do hear shareholders, what the reaction is.

The answer may surprise you!

From the abstract:

"Overall, our findings support the argument that existing tools are insufficient to induce pro-shareholder change at highly resistant firms. In fact, firms targeted by vote no campaigns are more likely to add management friendly charter provisions and takeover defenses, suggesting that these firms feel threatened by the campaigns and negative publicity."

WOW!

A bit more on the paper:

The basic issue that is investigated is whether no votes that lack a majority matter. The authors find that they do matter, but unfortunately, the votes actually may make things worse!

"in practice shareholders cannot legally remove a director that fails to act in their interests short of waging a costly proxy solicitation contest. Even a majority of shareholders ‘voting against’ a director would not result in his removal from the board because directors almost always run unopposed and only require a plurality of shareholder votes to be elected."

So what can shareholders do if the board candidate is running upopposed?

"While shareholders cannot technically vote against a director running unopposed,they do have the ability to withhold their vote from one or more directors up for election, and the right to publicly and privately encourage other shareholders to do the same. Thus, a substantial ‘withheld vote’ in a director election is another mechanism for shareholders to communicate their dissatisfaction. Some argue that a substantial withholding of the vote is enough of a public embarrassment to generate an immediate board response to shareholder concerns, and thus current tools are sufficient. The public spectacle associated with the recent annual meeting at Walt Disney Co is a case in point."

However, this paper finds that Disney was the exception and not the rule:

"Overall, our results provide little support that vote no campaigns are motivated by special interests, but do support the argument thatexisting tools are insufficient to induce pro-shareholder change at highly resistant firms."

Definitely an interesting finding. While it makes perfect sense, I had hoped that the negative publicity surrounding these events would have been enough of a "kick in the pants" to get boards to watch out for shareholders. Apparently the opposite is true. The "kick in the pants" is just enough to create a bunker mentality where the boards move further from shareholder interests.

Stay tuned, I predict more work in the area. The authors have brought up some interesting questions!

"The U.S. Commodity Futures Trading Commission (CFTC) today announced the filing and simultaneous settlement of charges under the Commodity Exchange Act (CEA) that Trade Exchange Network Limited (TEN), a limited liability company based in Dublin, Ireland, solicited and accepted orders from U.S. residents for commodity option contracts that were not excepted or exempted from the Commission’s ban on options. TEN owns and operates an Internet-based trading platform that facilitates trading through its websites www.Tradesports.com, www.Intrade.com, and www.TradebetX.com."

Short Version:The authors use a corporate Governance index to examine cash holdings by firms. They report evidence that firms with weaker governance waste the cash faster.

Longer Version:

Is cash good or bad? The correct answer is Yes. It is both. I'll be lazy and quote my dissertation:

"Two theories have been used to explain cash’s role decision making. The first, and more widely accepted model, is an agency costs theory.This agency theory, typically called the “free cash flow problem” and generally credited to Jensen (1986), holds that excess cash is detrimental to shareholders because managers will waste it through overinvestment and diversifying acquisitions.Not everyone believes this agency cost theory is a good explanation of reality.Skeptics claim that you cannot have too much of a good thing, and cash is a good thing because it allows firms to avoid the costs, mispricing, and delays involved in a security issuance.This second position, called the market friction theory is widely cited by managers as the reason for holding large cash positions.

"

If you are like me and largely accept the agency cost explanation, then at first glance it may appear surprising that Harford, Mansi, and Maxwell find that firms with poor corporate governance (as measured by the the Investor Research Responsibility Center) have small cash reserves:

"We start with the hypothesis that stronger shareholder rights (weaker managerrights) will lead to smaller cash holdings, all else equal. However, as noted above, we find the opposite."

Why is this the case? It appears that this finding is because the firms with weak governance spend the money faster!

Again in the author's words:

"...for a given set of firms with high levels of cash, all else equal, the firms with weaker shareholder rights will spend that cash morequickly. Our tests show that this spending is primarily on acquisitions."

That firms with higher agency problems spend the money faster would partially explain why some firms, who probably not coincidentally often have high insider ownership--and thus arguably less severe agency problems--Weis and Microsoft immediately come to mind) for years had consistently high levels of cash and yet did not appear to be adversely affected by their holdings.

A few other tidbits from the paper:

*"The results from the models using GIndex segmented into weak and strong governance firms, suggests that firms with strong management rights hold less cash but firms with strong shareholder rights do not hold more cash than the average firm, which indicates a non-linear relation between GIndex and cash holdings."

* The authors make a good attempt at controlling for the endogeniety problem:

"Although we find that the governance index is negatively related to cash holdings, the OLS regressions may not fully account for potential endogeneity in the sample. Modeling the relation between governance and cash holdings may be problematic if there is an endogenous feedback from cash holdings to governance. That is, cash holdings and the governance index are jointly determined....."

They control for this (at least partially) by using the Granger causality tests using lagged governance scores. The finding?

"We find that the governance index is statistically and significantly related, at the 5% confidence level, related to the future cash holdings of the firm. Firms with strong management rights (high GIndex) shed more cash from one period to the next overall our sample period."

* They also examine cash-rich and non cash-rich firms and report important differences that are tied to acquistion activity:

"For the high-cash sample...both weak and strong governance firms revert toward the normal level of cash for their industry. However, the weak governance firms revert significantly faster. For the increasing cash flow sample, we see that the stronger shareholder firms see an increase in their cash holdings. For the weak governance firm there is no increase in their cash holdings and the difference between firms based on their governance score is significant."

The MFA Distinguished Scholar Lecture will be given by .Chicago Marriott - Michigan Avenue

Members and friends of the MFA are invited to submit papers to be considered for presentation at the 55th Annual Meeting. Papers on any topic related to financial economics, financial planning or financial education will be considered. In addition, there will be a symposium of foreign exchange markets. Papers accepted for the symposium will be considered for inclusion in a special issue of the 'International Review of Financial Analysis.' Click for more details. The paper submission deadline has been extended to October 28, 2005."

Monday, October 03, 2005

I may or may not get anything online today. Have to make out a test and finish correcting projects. I will try.

In the meantime, I suggest you check out two recent posts (or collections of posts) at FreeMoney Finance.

1. Is about monkeys investing (it really can not get much better than that!). Short version: Due to market efficiency (or thereabouts) indexing, while not perfect, is good way to invest.2. A personal finance discussion of debt and how to reduce your debt. Carnival of Debt Reduction

I'll try to post something new material after class today, but no guarantees. Sort fo swamped right now!

Saturday, October 01, 2005

This is one of those things I realize from an intellectual point of view I should be happy about, but that said, it still saddens me.

From Yahoo News (the AP)"The Mississippi coast, wracked by Hurricane Katrina, is caught up in a real estate rush, as speculators and those looking to replace their own wrecked homes pinpoint broken and battered waterfront neighborhoods. In the weeks since the hurricane, prices of many homes — even damaged properties — have jumped 10 to 20 percent.

But what Katrina spared, the real estate rush now imperils. The arrival of speculators threatens what's left of bungalow neighborhoods that are among the Gulf's oldest communities, close-knit places of modest means where casino workers, fishermen and their families could still afford to live near the water."